Evolution of Emerging Market Debt

Investors are closely reevaluating their portfolios following a global credit crisis and currently facing the headwinds of increasing sovereign credit risk, rising inflation, and escalating worldwide fiscal deficits.

As investors find themselves looking outside the more traditional fixed income assets, interest has increased in the category of emerging market debt (EMD). EMD is debt issued by entities domiciled in under-developed nations. As a whole, EMD obligations have demonstrated resilience during this recent turbulent period. Historically, when compared to developed market fixed income, EMD has been considered an unstable asset class. However, volatility in EMD investments has been trending downward over the last few years due to strength in the underlying fundamentals and the maturity of this asset class. Capital inflows into EMD have been staggering, with a record breaking $76 billion moving into EMD in 2010. We believe this trend will likely continue as more investors recognize the relative strength of these fast-growing economies.

Why has EMD been so resilient? The broadened acceptance of this asset class is predicated on the significant improvement in the economic fundamentals of emerging market countries. This is primarily due to less restrictive government regulations, abundant access to natural resources, and a large and innovative working-age population. Emerging market countries are economically healthier in comparison to what they were a decade ago. Stricter monetary and fiscal policies, as well as robust trade flows, have led to strong current account surpluses and foreign exchange reserves. These factors have given EMD the ability to avoid, or otherwise mitigate, adverse global shocks.

Historically, the most common way to access EMD has been to invest in dollar-denominated sovereign debt. This type of debt investment provides a relatively high level of transparency (governments face constant global scrutiny over monetary and fiscal policies) and gives an investor the ability to avoid the volatile currency movements of the issuing sovereignty. However, the universe of dollar-denominated EMD securities has diminished as emerging market countries have increased their use of excess reserves to pay down external debt. This decrease in supply, coupled with a sustained belief that emerging markets will continue to outpace the economic growth and stability of more developed nations, has investors considering a broader set of alternatives including local currency sovereign debt, dollar-denominated and local currency corporate debt, and inflation-linked assets.

Although the currency risk associated with local currency EMD is real, it is imperative that investors allow for some degree of local currency exposure in order to take advantage of the complete opportunity set of EMD. Many emerging market countries are decreasing their financial dependence on the dollar, thus increasing the investable universe of locally denominated debt. In contrast to developed markets (particularly the United States, Europe and Japan), where debt as a percentage of gross domestic product (GDP) has increased significantly, local currency EMD as a percentage of GDP has remained flat. Local and dollar-denominated debt issued by the same government typically carry differing credit ratings due to the fact that governments have the ability to service their locally issued debt through various fiscal and monetary efforts, making locally issued debt less subject to the risk of default.

As emerging countries’ debt markets continue to evolve and creditors capitalize on the growing pools of available liquidity, the availability of corporate credit is expanding at a rapid clip. Issuance now spans over 35 countries and includes a variety of sectors including telecom, oil and gas, minerals and mining, and banking. Emerging markets corporate fixed income should provide diversification within portfolios and incremental yield through investments in quality issuers.

The inflation-linked bond market allows investors to capitalize on the attractive real yields that emerging market countries provide, without the inherent inflation risks in nominal bonds. The issuance of inflation-linked emerging markets debt extends to approximately a dozen emerging market countries. As the demand for these types of securities increases and inflation pressures mount worldwide, it is fair to expect issuance from additional emerging market countries in the near future.

While the risks associated with EMD that investors have traditionally sought to avoid still exist (political instability, protectionism, currency management, etc.), the long-term systemic effect of those risks on the asset class has diminished relative to more developed nations. The consensus opinion is that these risks are more likely to result in short periods of heightened volatility, rather than long-term disturbances in the secular maturation of the asset class.

The majority of emerging market countries have gone from current account deficits to surpluses. This has led to an increase in their currency reserves, and lower and more sustainable inflation rates as they have transitioned from fixed to floating exchange rates. Moreover, these improved fundamentals are also supported by significantly higher GDP growth rates (IMF forecasts GDP growth of roughly 6% for emerging markets through 2014 versus approximately 2% for developed countries).

For most investors, the access, breadth and liquidity of mutual funds will provide the appropriate exposure to EMD. The mandate of the specific mutual fund the investor chooses can vary widely, from globally diversified, to industry or geographically focused, to dollar-hedged or -unhedged, depending on the investors’ preference.

In summary, the relatively new development and evolution of EMD securities has provided skilled portfolio managers with the potential to provide investors with many opportunities to exploit mispriced markets, increase their diversification among fixed income investments, and achieve more attractive risk/return characteristics within their overall portfolio.